PepsiCo Q3 2007 Earnings Call Transcript

Oct.11.07 | About: PepsiCo Inc. (PEP)

PepsiCo Inc. (NYSE:PEP)

Q3 2007 Earnings Call

October 11, 200711:00 am ET

Executives

Jane Nielsen - IR

Indra Nooyi - Chairman, CEO

John Compton - CEO, PepsiCo North America

Mike White - Vice Chairman, CEO PepsiCo International

Richard Goodman - CFO

Analysts

Bill Pecoriello - Morgan Stanley

Lauren Torres - HSBC

Christine Farkas - Merrill Lynch

Bonnie Herzog - Citigroup

Judy Hong - Goldman Sachs

Ann Gurkin - Davenport& Co.

Brian Spillane - Banc of AmericaSecurities

Bill Leach - Neuberger Berman, LLC

Matthew Riley - Morningstar

Alec Patterson - RCM

Robert van Brugge - Sanford Bernstein

John Faucher - JP Morgan

Kaumil Gajrawala - UBS

Operator

Good morning andwelcome to PepsiCo's third quarter 2007 earnings conference call. (OperatorInstructions) It is now my pleasure tointroduce Ms. Jane Nielsen, Vice President of Investor Relations. Ms. Nielsen,you may begin.

Jane Nielsen

Thank you, operator and good morning, everyone. Thanks toall of you for joining us. Today's webcast includes a slide presentation thatcan be accessed at our PepsiCo.com website.

Before we begin, please take note of our cautionarystatement. This conference call includes forward-looking statements based onour current expectations and projections about future events. Our actualresults could differ materially from those anticipated in such forward-lookingstatements, but we undertake no obligation to update any such statements.

Please see our filings with the Securities and ExchangeCommission including our annual report on Form 10-K for a discussion ofspecific risks that may affect our performance. You should refer to the investorssection of PepsiCo's website under the heading PepsiCo Financial Press Releasesto find disclosures and reconciliations of non-GAAP financial measures that maybe used by management when discussing PepsiCo's financial results withinvestors and analysts.

This morning's prepared remarks will be made by Indra Nooyi,PepsiCo's Chairman and CEO; Mike White, PepsiCo's Vice Chairman and CEO ofPepsiCo International; John Compton, CEO of PepsiCo North America; and RichardGoodman, PepsiCo's CFO. After our prepared remarks we will have time forQ&A.

I would like to call your attention to one item that affectsthe comparability of the numbers we reported this morning. We had a non-cashtax benefit in the quarter totaling $0.07 per share, or $115 million, relatedto the settlement of a tax audit in one of our international businesses. Ontoday's call we'll refer to the results, excluding the item I just mentioned,as core results which we believe are more indicative of our ongoingperformance. The net is that our core EPS grew 11% for Q3 and 14% year-to-date.

It is now my pleasure to introduce Indra Nooyi.

Indra Nooyi

Thanks, Jane and good morning, everyone. We truly appreciatethe opportunity to discuss PepsiCo's third quarter results and our outlook forthe balance of 2007. As you read in our press release this morning, PepsiCocontinued our strong performance in the third quarter, delivering double-digitgrowth in revenue, division operating profits and core EPS.

With three quarters of the year now behind us, I would liketo share my perspective on our business performance this year, our M&Ainitiatives, and the many advances we've made in our sustainability agenda.Finally, I'd like to spend a minute sharing my thoughts on our outlook for 2008,before I toss it to John Compton, Mike White and Richard who will then take youthrough the business segments and corporate costs in more detail.

Let me begin with business performance. I must say that I amvery proud of the results our team has achieved. The powerful combination ofour portfolio, the advantage business model and the complete dedication of ourassociates across the globe has resulted in excellent top and bottom lineperformance year-to-date: 10% net revenue, 10% division operating profit growthand 14% core EPS year-to-date performance.

Every division has effectively managed increased input costinflation with a combination of pricing, mix and productivity. They've achievedin the process the right balance between consumer value and margin management.

Now, we had the benefit of a generally favorable globalmacroeconomic environment and a forex upside; but we have also taken theopportunity to reinvest some of our upside in order to enhance our marketcompetitiveness, as well as to drive strong, sustainable growth.

On the acquisition front, we executed several tuck-inacquisitions. In Q3, as you read, we closed the Sandora acquisition, and inpartnership with Pepsi Americas we're now the leading beverage company in the Ukraine.Most recently, we announced the acquisition of the Lucky snacks business in Brazil,and we've also built upon our successful partnerships with Unilever andStarbucks by expanding our international markets.

With the North American beverage segment, while not anacquisition, we established a relationship with Dale Earnhardt Jr. that will helpus accelerate our growth in energy drinks. So far this year we have spent abouta $1 billion in acquisitions, and that does not include the Lipton and theLucky snacks deal which are still pending regulatory approvals.

Our business results and growth platforms are also enhancedby the progress we're making in our environmental sustainability agenda,reducing water and energy consumption, increasing recyclable materials in ourpackaging, and leading innovative carbon footprint labeling. In recognition ofour efforts, I'm proud to report to you that PepsiCo retained its place on theDow Jones Sustainability North American Index, and in September, we were addedto the Dow Jones Sustainability World Index which is comprised of companiesleading sustainability efforts around the world. For the balance of the year,we expect to make further progress in all three of these important areas.

Let me now turn to 2008 and briefly touch on the year comingup. I remain confident in our ability to deliver our long-term algorithm of midsingle-digit volume growth, a positive spread between volume and revenue and atleast 10% EPS growth.

But before I turn the call over to John Compton to discuss North America, I want to share some thoughts on the economic landscape. Clearlythe acceleration of commodity prices, particularly grains, cooking oils andenergy is top of mind for all of us in the food and beverage business.Domestically in North America, while commodity costincreases were slightly lower than we had forecast in the first half of thisyear, they've been higher than expected in the second half. For 2008, we thinkthe second half trend will actually continue.

At this point, we are projecting North American inflation onour strategic inputs, excluding orange juice, to be more than 1 percentagepoint above this year's low single-digit rate, and we are expecting a similarpattern in many international markets, as well. To address this headwind, weare employing many of the same levers that have enabled us to navigate thischallenge successfully over the past couple of years, namely, a combination ofincreased productivity, rate increases, and cross utilization through mixedmanagement.

While we are addressing the inflation issue, we are alsosensitive to the possibility of slower U.S.economic growth in the coming year. History will suggest that the nature of ourproduct portfolio and our structural advantages will allow PepsiCo to be muchmore resilient than most other businesses in such circumstances; and, we clearlyhave a much broader global footprint than at any time in the past and webelieve that our more diversified portfolio will enable us to continue tocapitalize on the favorable macroeconomic climate in most of our internationalmarkets.

Nevertheless, as we move into our planning cycle for 2008,we'll be alert to the potential challenges and will be building in thenecessary flexibility to adjust to changes in the overall economic environment.

In total then, I want to reiterate how pleased I am with ourperformance this year and how committed we are as a team to execute across ourbusinesses with excellence and consistency going forward.

Now let me turn the call over to my good friend, JohnCompton, to discuss our North American business in more detail.

John Compton

Thank you, Indra andgood morning, everyone. In North America we clearly madevery good progress on a number of fronts in Q3. Looking across the entireportfolio, I want to particularly note our ability to manage input costheadwinds while expanding our operating margins 50 basis points. As a result,North American revenue increased almost 5%, and profit growth showed sequentialimprovement, achieving 7% growth in the quarter, our strongest overall profitgrowth this year.

Let me start first with Frito-Lay North America, our largestdomestic business, which once again delivered balanced top and bottom lineperformance. Revenue grew a solid 6% through a combination of solid volumegrowth and price mix benefits of almost 4 points.

Importantly in the quarter, Frito-Lay again drovemanufacturing productivity, which helped offset inflation. In total, Frito-Layexpanded operating profit margins by 25 basis points and realized 7% growth inprofits. This is particularly impressive as input cost inflation accelerated onkey items like cooking oil, corn and fuel.

Importantly, Frito's wins extended to the marketplace,growing both savory dollar and volume share. Volume growth drivers in the thirdquarter were balanced between core salty brands and Quaker snacks, with highsingle-digit growth in Doritos and double-digit growth in dips, multi-packs,SunChips, Stacy's and Quakes Rice Cakes.

One key element driving the continued success of the Doritosbrand is sustaining the meaningful innovation. Last year's success, Blazin'Buffalo Ranch, clearly met consumer's desire for flavor intensity. The Doritosteam followed that success with our recently introduced Doritos Collisions,which delivers both flavor intensity and complexity by mixing mild and spicyflavors in the same bag. Collisions is off to a terrific start.

Multi-packs offer a great portion control option and areproving increasingly successful. The package has broad appeal for moms lookingfor lunch box options, to boomers with smaller households looking for varietyin a size that's just right for them. At the same time, one area that continuedto be soft was brand Lay's where volume in Q3 was down mid single-digits,primarily as a result of the weight-up/price-up strategy implementing in the fourthquarter of last year.

We have recently taken a number of steps to address thisissue. First, we have changed the packaging to a new global Lay's design.Second, we've been able to significantly expand our kettle chip offerings nowthat capacity is on stream, and this is particularly important given thestrength of the kettle category. Soon, we will be introducing a new mid-sizedline that will be more attractive to smaller households. We are encouraged bythe early signs of the improvement in the business in the first few weeks ofQ4.

Beyond our results, I'm proud of the progress Frito-Lay ismaking in reducing our usage of water and fuel, down over 30% and 20%respectively since 1999. The Jonesboro, Arkansasplant recently earned the EPA's Performance Track Program distinction for itsenergy conservation and waste water reductions. Net another strong, balancedquarter from the Frito-Lay team.

Turning to our beverage business, we successfully managedthrough a challenging summer period. In the quarter, volume was down 1%;revenues though were up 3% and profit grew 7%, our strongest profit growth ofthe year. All of us recognize that a 1% volume decline is not in line with ourexpectations for this business. However, as a number of you noted in your reports,the months of June and July were unseasonably cool and rainy and had an impactacross all beverages, particularly Gatorade. Fortunately, August returned tonormal -- in fact, a few degrees hotter than the previous year and the businessin total responded, driven by Gatorade. It's encouraging to see the positivemomentum in the Gatorade business continuing through September.

Now starting with our hydration brands, our water portfoliogrew high single-digits led by double-digit growth in Propel and SoBe Lifewater.Gatorade did decline mid single-digits in the quarter but as I said, exitedwith strength. That strength is continuing in Q4, consistent with our long-termguidance of high single-digit growth.

Looking forward, we have exciting news across these brandsthat will set the stage for Q4 and beyond. Let me take a minute to take youthrough some of the new product launches that we believe will fuel significantincremental growth.

At the heart of our effort to restore high single-digitgrowth to the Gatorade trademark is the launch of G2. G2 is a low calorie,electrolytic beverage with just 25 calories per eight-ounce serving; half thecalories of Gatorade, but with all the electrolytes. It expands the Gatoradeproduct line to now meet the hydration needs of athletes on a 24/7 basis.

Equally important, Propel is introducing a new lineextension, Propel Invigorating water. This fitness water from Propel is mildlycaffeinated and lightly flavored with only 20 calories per 8-ounce serving.It's designed to not only hydrate and nourish, but to also provide a boost foractive people throughout the day.

Additionally, we are relaunching SoBe Lifewater. SoBeLifewater is being reformulated with sucrose -- which as you know, is tablesugar -- antioxidants, vitamins and natural herbs. Each flavor will have aunique blend of ingredients offering a distinct benefit. SoBe Lifewater's newformulation will have lower calories than before and fewer than ourcompetitors. At the same time, we are leveraging our bottler's distributionpower in select channels and packages to maximize the availability of G2 andthe entire Propel line.

Turning to CSDs, we gained volume and value share in thequarter. However, the category as a whole continued to suffer volume declinesand our own CSD volume fell 3%, led by declines in trademark Pepsi. At the sametime, innovation did drive growth in certain segments as Mountain Dew, GameFuel and Diet Pepsi Max each gained a half a share point in Period 9. GameFuel's unique linkage with Microsoft Xbox launch of Halo 3 connected withtarget consumers and enabled trademark Mountain Dew to deliver positive growthin the quarter.

Beyond CSDs, the strong momentum of our ready-to-drink teascontinued with growth over 20% and significant gains in both volume and valueshare. Energy also posted over 20% growth, led by an almost 70% increase inMountain Dew AMP. As we noted on the second quarter call, we are increasinglyfocused on the AMP brand and will turbocharge our performance in 2008 as weleverage our relationship with NASCAR legend Dale Earnhardt, Jr., who willdrive the number 88 car with Mountain Dew AMP as the lead sponsor.

Our portfolio of juices and juice drinks continued on track,realizing net revenue gains to offset significant inflation. In our recentlyacquired Naked Juice business, we just introduced the first 100% juice smoothiewith probiotics, which as you know, aid in digestive and immune health.Tropicana will be extending its Pure line in early Q1 which we believe will fuelgrowth in 2008.

Overall in beverages with our powerful brands, with greatinnovation and our strong growth go-to-market systems, we will finish the yearwith accelerated momentum that will carry into the coming year.

Turning to Quaker Foods North America, the division reported2% revenue and 2% NOBIT growth, about in line with our expectations. The 2%volume decline, in part, reflected price increases to cover inflation in keyraw materials and in part, shipment timing. The fall product rollout was in Q3last year and is in Q4 of this year. In terms of innovation, we are veryencouraged by the strong early results in the launch of Simple Harvest, whichmoves the Quaker trademark beyond oats to multiple grains.

All in all, I am very pleased with our performance in North America. Going forward we expect Frito-Lay to remain strong andour beverage portfolio is now primed for growth.

Let me now turn the call over to Mike White.

Mike White

Thanks very much,John and good morning, everyone. The underlying fundamentals for PepsiCoInternational also remain very strong, enabling us to deliver another terrificquarter with revenues up 22% and our operating profits up 19%.

Importantly, I think we had solid volume and market sharegrowth across both our snacks and beverage categories. We obviously continue tobenefit from a favorable macroeconomic climate internationally, and especiallyin emerging markets. However, many of our markets are also managing the risinginflationary pressures that are impacting our North American colleagues. Wehave seen this most particularly in Mexico where corn, wheat and cooking oilshave all increased in price significantly this year.

Clearly too, both the reported revenue and operating profitgrowth reflected the benefit of some forex upsides as well as M&A and so Ithought I would take a moment just to put our financial results into theappropriate context for you.

First, in addition to the acquisition of the Bluebird snacksbusiness in New Zealand and the divestiture of the Sugar Puffs cereal businessin the UK, our third quarter results were impacted by our increased equityownership in several of our beverage joint ventures in China, as well as thebuyout of our joint venture partner in a snacks JV encompassing several CentralAmerican countries. Now in the past, we reported no revenues and only our shareof net income for those joint ventures. Now we're consolidating the revenues aswell as the profits; reporting all the revenue, as well as our increased shareof the profits.

Now the impact of full revenue consolidation plus thecreation of our Russiajoint venture with PBG and some year one integration costs are the primaryreasons that total M&A activity added 7 full points to revenue growth, buthad minimal impact on operating profit growth for the quarter. By the way, thisalso accounted for more than 100% of PI's reported operating margin decline inthe third quarter. In fact, excluding the impact of all these M&Aactivities, margins improved by almost 50 basis points in the quarter, which isright in line with the expectations I've had and previously have communicatedto you for our business.

Second, although forex tailwinds added 6 points of revenueand operating profit in the quarter, we made a conscious decision to reinvest aportion of that upside in the third quarter and will be continuing to furtherreinvest in selected strategic markets in fourth quarter as well.

Third, as you saw in the press release, there was acombination of several other items: some lower amortization expenses and highercosts related to the international SAP implementation, and a few favorableitems from 2006 that we were lapping which in total reduced operating profitsby 3 percentage points.

So net-net I think we continue to deliver underlying top andbottom line results well in line with our long-term algorithm, while continuingto invest in the business to sustain our growth going forward in themarketplace.

Let me now take a minute to review some of the key factorsas I look at the quarter impacting our business results, starting with oursnacks business. Snacks volume was up 7% in the third quarter, largelyreflecting an average growth rate of over 10% in all of our countries excludingthe big three -- Sabritas, Walkers and Gamesa. This broad-based growthcontinues to be fueled by outstanding innovation and marketing activity andstrength in emerging markets. For instance, in Saudi Arabia, the national launch of Doritos ishelping that business grow over 30%. In China,Lay's was voted China'sfavorite salty snack brand for the seventh year in a row.

As we grow, we're also gaining market share. Our totalsystem volume share was up almost 1 percentage point in the most recenttrimester.

As it relates to the big three businesses, starting withSabritas, at Sabritas we took pricing at the end of last year as you'll recallfrom our previous calls, to offset significant expected inflation. Thisresulted in the modest volume declines that we expected and planned for, but italso enabled us to achieve the expected positive revenue growth and profit flowthrough, in line with our expectations. Recent innovation and promotions likeRuffles Extra Hot and [inaudible - Spanish] continue to provide excitement toconsumers and have driven a 1 point increase the in our market share in Mexico.So net-net, Sabritas is right in line with our expectations for the quarter aswell as year-to-date.

At Walkers, volume was down low single-digits in thequarter. Having said that, we did continue to gain market share in all of ourkey accounts. However, this was more than offset by some category softness, inpart I think reflecting the poor summer weather in the United Kingdom, as well as some pricing pressure inthe non-traditional channels.

Having said that, I am confident that we've got the rightplans in place to reignite growth going forward. For instance, to fuel demandwe're launching Sunbites in the fourth quarter, which is our United Kingdom version of the successful U.S.SunChips brand that continues to go from strength to strength in John'sbusiness in North America. On Crisps, our advertising isgoing to focus on something called the great British potato, a campaign thatwill remind consumers of the local and wholesome goodness of their Crisps andthe fact they're all grown in the United Kingdom.

In the marketplace, we'll refine our sales execution and ournet revenue realization processes to ensure that we win across all of ourchannels. We'll couple that with continued tight cost control and drives foradditional productivity.

In Gamesa, we had double-digit volume in revenueperformance, led by the continued success of our high end product lineup, and avery successful [inaudible – foreign language] promotion. Our biscuit marketshare was up 1.3 percentage points and I'm very proud of the team there.

At the same time however, Gamesa too faced very, verysignificant levels of wheat and cooking oil and shortening inflation. In orderto successfully manage those cost increases, Gamesa took pricing actions inboth August and September. So looking ahead at Gamesa, I do expect a bit morebalance between volume and revenue to drive our operating profit growth.

Turning to our beverages portfolio, volume for the quarterwas up a very solid 8%, led by double-digit growth in key emerging markets likeChina, Russia, Pakistan and the Middle East. Carbonated soft drinks grew 8%,led by terrific growth from Mountain Dew, 7-Up and Mirinda; all of our flavorportfolio, in fact. Non-carbs were also up double-digits, driven by 40% growthin our Lipton ready-to-drink teas.

Great innovation is at the center of all of thatperformance. Our product 7-Up H20 continues to do extremely well as it gainstraction in both existing Latin American markets like Argentinaand Brazil, aswell as new markets such as Irelandand Vietnam.

In China,we had tremendous excitement by the Pepsi Creative Challenge 2 Face On the Canwhere we had 2.5 million photos submitted for 20 spots on a Team Chinacommemorative Pepsi can, and where we had, through the web, 140 million votescast to determine the winners. This is truly what we call 360-degree marketingat its very best, and I'm sure you've seen a bit of the press we've got incelebrating Team Chinawith yes, a red Pepsi can.

Net-net the fundamental performance of our internationalportfolio continues to be very strong.

Let me make just a couple of comments on acquisitions. Firstin August, as you know, in partnership with our bottler Pepsi Americas weclosed on the purchase of an 80% stake in Sandora, the leading liquidrefreshment beverage and juice company in the Ukraine.In September we announced the expansion of two very successful partnerships. Weadded 11 countries, especially in Western Europe, to ourexisting international Pepsi-Lipton joint venture, a truly global partnershipfocused on the world's number 1 brand of tea in the fastest growingready-to-drink tea segment.

Second, we extended our coffee partnership with Starbucks tointernational markets, bringing together the great Starbucks brand and coffeeknow how with PI's beverage experience and distribution capabilities. Our firstmarket for entry with Starbucks is going to be Chinawith Frappucino.

Recently, we announced the acquisition of Comercio de DocesLucky, a Brazilian snack company, which will add a couple of well-recognizedbrands --a wheat brand and an extruded brand -- as well as manufacturingcapacity in strength and distribution to the lower end consumers in Brazil. Itwill fit brilliantly with our Brazilian snacks business.

Finally on the sustainability front, I'm extremely proudthat UNICEF recently selected PepsiCo Exnora International zero wastemanagement project in Indiaas a model project and a center for international learnings in the area of urbansolid waste management. We started this partnership with Exnora International,an environmental NGO, in 2005.

So in summary for PI, our top and bottom line performancewas strong and broad-based across our geographies, snacks and beverages both.Our businesses are executing well and are doing a great job managing input costheadwinds. Recent tuck-in acquisitions are all on track, meeting ourexpectations and we're bringing new product opportunities to our portfolios. Oursustainability and corporate social responsibility agenda continues to moveforward in all of our markets.

With that, let me turn the call over to Richard.

Richard Goodman

Thanks, Mike and good morning, everyone. As you saw in ourrelease, we delivered a strong quarter with revenue up 11%, division operatingprofits up 10%, and core earnings per share increasing 11%. This brings ouryear-to-date growth to 10% revenue, 10% division operating profit and 14% coreearnings per share. Our Q3 line of business operating margin was slightly lowerthan last year's on a reported basis. However, excluding the compression fromM&A activity that Mike White just talked about, PepsiCo's overall LOBmargin improved slightly.

What I would like to do now is to cover our corporate costs,period taxes and cash flow and then review our balance of year outlook.

For the quarter, corporate departmental expenses were upslightly, in line with inflation. We did see a $28 million negative swing inmark-to-market commodity hedges which, as expected, reversed the gains we hadexperienced in the first half of the year. Finally, the combination of deferredcompensation and our hedges against that compensation exposure basically nettedto zero, but we're required to report the deferred compensation upside in corporateunallocated and the corresponding hedge downside below the line in interestincome. That compensation hedge downside actually accounted for abouttwo-thirds of the increase in net interest expense. The rest of the increaselargely reflected higher net debt as a result of acquisitions.

Bottler equity income was up $14 million in total on higherequity income pickup, offset in part by slightly lower gains on the sale of PBGshares.

For the quarter, our core tax rate was 27.4%, about 40 basispoints higher than prior year, but still slightly better than we had originallyforecast, largely reflecting timing between Q3 and Q4 tax items.

Lastly, our weighted average diluted share counts decreased2.2% as a result of the stepped up share repurchase program authorized by ourBoard of Directors earlier in the year.

In total then, below the line items provided 1 point ofleverage from LOB to core EPS, driven primarily by the lower share count andpartially offset by the mark-to-market losses and the slightly higher effectivetax rate.

Moving on to cash flow, year-to-date cash from operatingactivities is trending a little better than our $7 billion guidance for thefull year, and our capital expenditure forecast remains consistent with ourfull year guidance of $2.6 billion. The net of these two, what we callmanagement operating cash flow, is expected to be slightly ahead of guidanceand to increase about 10% versus 2006.

We have returned $4.7 billion to shareholders this year,$1.6 billion in dividends and $3.1 billion in share repurchases. That's up $1.2billion or 34% versus prior year. We expect cash to shareholders to be up thispercentage for the full year as well, reflecting both higher share buybacks andthe 25% increase in dividends we announced in May.

I'll turn now to our balance of year outlook. We expect ouroperating divisions to continue their solid performance in this fourth quarter,but we will also be reinvesting back in the business. In addition, we are nowexpecting a higher full year tax rate as a result of recently announced changesin Mexico's tax legislation. We're still reviewing the implications, but inaddition to a higher effective tax rate when the legislation takes effect in2008, there is a FAS 109 impact in 2007 related to the loss of certain deferredtax benefits.

Our preliminary estimate is that our full year 2007 core taxrate will probably be up to 40 basis points higher than the 27.3% we hadpreviously communicated. That tax downside is why even with the strong Q3results, we are simply maintaining our full year core earnings guidance of atleast $3.35 per share.

Our core Q3 results and the core full year guidance excludethe impact of the conclusion of an international tax audit which resulted in aQ3 tax gain of $115 million, or about $0.07 a share.

In our full year core guidance we are also excluding theimpact of certain Q4 restructuring actions, some of which we have recentlyapproved and some of which are in process for which we expect to take chargesin Q4 of around $0.03 a share. These relate to plant closings and to therationalization of production lines in both our international and domesticbusinesses, all done to drive further productivity in 2008 and beyond.

In total then, very good results in Q3 which put us on trackfor core EPS growth of about 12% for 2007.

Before I turn the call back to Indra for her closingremarks, I would like to clarify the facts regarding the size of our businesswith Wal-Mart, our largest customer. An article in The Wall Street Journal lastweek included a chart showing PepsiCo's North American business with Wal-Martas a percentage of revenues from 2003 to 2006. The basis for the chart was thedisclosures that we made in the non-financial section of our 10-K filingsrelating to the concentration of business transacted with a particularcustomer.

Over the past several years, we have identified Wal-Mart asour largest retail customer worldwide and one that represents over 10% of ourNorth American revenues. As you know, Wal-Mart in North America operates inboth the mass channel with its Wal-Mart stores and in the club channel withSam's. In our 2003 and 2004 filings, the percentage of sales that we reportedfor Wal-Mart included the stores in both channels. For 2005, however, we determinedthat it would with more appropriate to separate the segments and we thereforebased our 2005 and 2006 concentration disclosures solely on the Wal-Martformat.

We did not note the change in methodology since we weren'tanalyzing year-over-year trends and since there is no requirement to show timeseries data in this section of the 10-K. The chart that you are now seeing onthis webcast provides the facts over the 2003 to 2006 period. The first columnshows the percentages just for Wal-Mart formats and the second column shows thepercentages for Sam's Club.

As you can see, the Wal-Mart format increased as apercentage of PepsiCo's North American revenue every year from 2003 to 2006. That'sin column 1. Sam's in column 2 alsoincreased over this period; and indeed in every year as well, if you look atthe unrounded numbers.

So in summary, I hope and trust that this clarifies thematter. Now let me turn it back to Indra.

Indra Nooyi

Thank you, Richard. Let me sum up by saying that we are verypleased with the company's performance for the third quarter and year-to-date.The momentum for the business is very strong. We fully expect it to continuegoing to the fourth quarter.

Our innovation and deal pipeline remain robust and wecontinue to make selective investments in the business and continue to show,with the advances in our sustainability and corporate social responsibilityagenda, that performance and purpose can not only operate side-by-side, butactually unleash the creative talents of our 168,000 associates around theworld.

With that, operator we are glad to open the line forquestions.

Question-and-AnswerSession

Operator

Your first question is from Bill Pecoriello - MorganStanley.

Bill Pecoriello - Morgan Stanley

Given the commodity outlook that you describe looking outinto '08, can you give us some more color on how you're thinking about thevarious levers you have to offset this? Do you have an opportunity toaccelerate productivity initiatives in PBNA or FLNA or International? I knowyou've had ongoing programs in those divisions for many years but any moreopportunity to accelerate efficiencies there?

In terms of taking more price, you've seen some volumeimpact as you've taken price at Sabritas; Mike mentioned Gamesa. How are youthinking about those various levers looking into '08?

Indra Nooyi

Bill, as I said in my script, we're looking at all thelevers: productivity, mix management, pricing. We're looking at all of theselevers; for each product line, for each country we're reviewing what can bedone to offset commodity inflation. I don't think it's prudent to go to thatlevel of detail on this call, but rest assured there's no one lever that willbe deployed, it will be a mix of all three levers.

Operator

Your next question comes from Lauren Torres - HSBC.

Lauren Torres - HSBC

With your recent announcement that enables Pepsi bottlers todistribute G2 and the Propel line, I was just wondering at this point if thereis now a greater potential to transfer any of your existing warehouse deliveryof Gatorade to the bottlers? As a result of this announcement, are you thinkinga little bit differently about this brand?

John Compton

We see the opportunity to use the bottling system in thetrue up and down the street segment, in the C&G segment to launch the newG2 business and to transfer the entire Propel system over. We want to learnfrom this launch and see the benefits of DSD. We clearly know and have seen thebenefits of our warehouse system over the past five years, so we're eager tosee how the DSD system does with both G2 and Propel.

Indra Nooyi

If I could add to what John said, Gatorade to the warehouseis doing exceedingly well in large format. If we were to transfer to DSD andtake on the additional costs of DSD we would have to get a lift in Gatoradethat is extraordinary to make it work at DSD, and we don't see that kind oflift happening in large format because we're already well developed in largeformat. I see limited potential to move core Gatorade to the bottling system.

Operator

Your next question is from Christine Farkas - Merrill Lynch.

Christine Farkas - Merrill Lynch

John, I'm wondering if you could comment on Frito-Lay. Thevolume growth there was just a little bit below average. I'm wondering if thebulk of that is due to Lay's weakness or was there particular channel softness?

Indra, I'm curious to have your comments: if there is aneconomic slowdown, what would you be concerned with? Would it be certainproduct slow down or certain channel softness? Thank you.

John Compton

Yes, in the quarter, we probably should have noted this inthe script and I'm glad you asked the question. Frito-Lay's volume growth inthe quarter was around 2%. If you look at it on a year-to-date basis, we'rearound 3%. There was about a 1 point fall-off in volume growth. That's allattributed to a Fritos and Cheetos promotional event that we did last year inQ3 that we chose not to do again this year in Q3. That one event was worthabout 1 point of volume growth if the quarter.

Going forward, we see this business around the 2.5% to 3%volume growth business, and I think you'll see that continue in the future.

Indra Nooyi

When it comes to the economic slowdown issue, Christine, it'smostly specific channel slowdown and really how people might shop in terms ofpremium products versus value products and what opportunities we may have topush premium products and what kind of pricing strategies we have to deploy onproducts that are sold in all channels. That is what requires careful thinking.

If you go back to Bill's question on the commodity outlook,we are in an inflationary environment. In an economic outlook, which guessesare all over the place, we just have to be very judicious in deploying all ofthe levers and remain very flexible and agile so that we can actually flex withthe times as next year evolves.

Operator

Your next question comes from Bonnie Herzog - Citigroup.

Bonnie Herzog - Citigroup

I had a question just in terms of your global marketing spendingefforts. I'm curious, are you spending enough, do you feel? As a percentage ofsales, should we expect the amount that you're currently spending to increasein the future and possibly shift in terms of where the spending is allocated?

Mike White

Bonnie, certainly there's been an increase in our marketingspending this year and I expect that to continue, especially in emergingmarkets. I can't say that in the developed countries on either snacks orbeverages that I see a material change, when you think about it as a percent ofsales. I mean, obviously we continue to grow it in line with revenue in thosekinds of markets, but I think we're at about the right level.

We're working hard to drive productivity within themarketing line. I would say probably the bigger news is the shift within our A&Mspending towards more events linking in the web, like the Chinapromotion that I mentioned where we had 140 million votes on the web for thesephotos of individual consumers in China.

I think that kind of linkage of advertising, packaging andthe web, what I call 360-degree marketing, is much more of the news, if youwill, in the way we're marketing to consumers. Then yes, I would say wecertainly expect it to continue to be an intense marketing environment in keyemerging markets as it has been.

John Compton

Bonnie, on the North American side, clearly already thisyear we've invested in A&M in the Frito-Lay North American business. In thequarter, again, A&M grew double-digit, faster than the revenue growth andit's consistent with the year-to-date performance.

In the beverage business, really the only place where ourA&M spending has declined is in the Tropicana brand as we were trying toovercome the higher cost of oranges. You will see us as we launch G2 and Propeland Mountain Dew AMP support those brands in big ways with increased marketingsupport going forward.

Operator

Your next question comes from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

I just had a couple of financial questions. Richard, interms of the tax rate, your full year guidance implies that in the fourthquarter we may see a 30% plus kind of tax rate. Is that something that we couldbe looking at in 2008 going forward? Is the number really close to a 27.7% kindof number going forward?

Richard Goodman

Yes, you did theright squeeze. In Q4 it will be a tax rate above 30%. That's really a FIN 48impact and on a go-forward basis, I would expect the tax rate to be in the high27s, so about similar to where we are this year at the 27.7%.

Judy Hong - Goldman Sachs

Secondly, just in terms of your guidance for 2008, 10% plusEPS growth, does that assume similar level of the gain from sale of PBG stockin 2008 as well?

Richard Goodman

Yes. Right now that's assuming that, although we haven'tcompleted our entire planning cycle, but clearly we've been selling down ourshare in our anchor bottlers down to IPO levels. They continue to buy backtheir shares so we should continue to see share sales going forward, as well.

Operator

Your next question comes from Ann Gurkin - Davenport.

Ann Gurkin - Davenport

I wonder if we could spend a little time on Eastern Europe and your outlook for that market, and the opportunities tocross sell your brands, whether through the recent acquisition or perhaps CSDor snacks in those markets?

Mike White

Eastern Europe and Russiaboth have been really dynamic growth markets for us and I expect that tocontinue. For instance on the snack side, even small countries like Romaniahave just been on fire in Eastern Europe. We're workingon strategies to expand our presence in the Balkans, as well and our Russiabusiness continues very strong. Our Polandbusiness in snacks is doing very well. We are leveraging, for instance, PAS inCzech to distribute snacks in conjunction with their bottling presence there.

Certainly we have some plans, I think it's maybe a littlepremature for me to talk about for the Ukraine.Obviously, getting a big operating infrastructure there gives us a distributionplatform that we did not have before to think about for snacks, and who knows,perhaps to even strengthen our CSD business in the Ukraine.

Certainly, for sure we continue to look at Eastern Europe. As I look at my Europe business, Eastern Europe and Russiacontinue to be the key growth engine for that business. I certainly expect usto continue power of one type initiatives which aren't really new for PI. Welaid that theme out four years ago and continue to work for opportunities toleverage it and I think there are still those kinds of opportunities for surein Eastern Europe, as well.

Ann Gurkin - Davenport

Great. Switching backto the earnings outlook for '08, does that include a level of concentrate priceincrease in the U.S.like we saw in 2007?

Indra Nooyi

We have not finalizedour concentrate price increasing plan as of yet.

Operator

Your next question comes from Brian Spillane - Banc ofAmerica Securities.

Brian Spillane - Banc of America Securities

A question on pricing power. If you look at what you've donethis year in terms of raising prices on Gatorade in the U.S., Sabritas inMexico, and I guess in other parts of the world where you've raised prices hasthe price elasticity or the demand elasticity been better or worse than you anticipatedis there any change in your thinking onpricing as you look forward relative to based on what your experience was thisyear?

Indra Nooyi

From my perspective, I think in pretty much in every countrythe elasticity was exactly what we expected. John, Mike, if you want to addsomething on pricing?

John Compton

As you've seen, year-to-date our Gatorade price in themeasured channels is up about 2.5% year over year. I think that's theelasticity of the business. I think that fits our model pretty well. Ourprimary competitor though in that segment declined their prices 4%. I don'tthink we expected that coming into the year. As we said on the last call, ourpricing on Gatorade that we took this year will carry us forward into 2008.

Mike White

I think inInternational I would say the same thing. Sabritas is just bang on all of themodeling we did last fall when we took the pricing and I haven't seen a change in any other markets. Certainly,we're gaining market share in those markets where we took pricing, so certainlyin terms of the competitive game, I don't think pricing has put us at adisadvantage. I think certainly as consumers see broad inflation across thewhole grocery store, we'll have to see how that plays out next year. Certainlyfrom a snacks and a beverage standpoint, I can't say that I've seen any newpattern from an elasticity standpoint that would change my thinking about howwe're planning for next year.

Brian Spillane - Banc of America Securities

Mike, just as on a rough basis, what percentage of yourbusiness did you actually take rate increases this year?

Indra Nooyi

That's a tough number to provide.

Mike White

Tough number toprovide, frankly. I really couldn't tell you that. Every country has gotdifferent inflation levels. In Russia,you're talking about 8% inflation in the economy. It's quite different acrossthe system. In International in general we have had probably more experiencewith pricing consistently, not just this year, but frankly, over the last fiveyears than perhaps the U.S.just because of the macro economic environments you deal with in emergingmarkets.

Operator

Your next question comes from Bill Leach – Neuberger Berman.

Bill Leach - Neuberger Berman

I was just wonderingif you could give us the PBG capital gain numbers, specifically? Also PBG had a$31 million after tax extraordinary gain in the quarter. How did you accountfor that?

Richard Goodman

I'll take that. Wepicked up our share of the $31 million in our equity income and that increasedour equity income by about $10 million in the quarter.

Bill Leach - Neuberger Berman

Could you give us thecapital gain in the quarter?

Richard Goodman

I think we had a gain of between $55 million and $60 millionon the sale of the PBG shares.

Bill Leach - Neuberger Berman

Is that a fullytaxable number or do you get a capital gains tax treatment on that?

Bill Leach - Neuberger Berman

Is that taxed at yournormal rate or is that a 15% capital gains rate?

Richard Goodman

Yes, it's taxable at a normal rate.

Operator

Your next question comes from Matthew Riley - Morningstar.

Matthew Riley - Morningstar

I was wondering, has your long-term outlook towardscommodity cost inflation changed at all over the past few quarters or past fewyears? I know we've heard out of some of the other large packaged foodcompanies that they're thinking more that this is a long-term trend. I know PBGsaid they like the 2% to 3% price increase world, but are we going to be facedwith a 4% to 5%?

Indra Nooyi

That is a tough onebecause a lot of it is supply/demand driven. Right now we're seeing escalationin prices of wheat, prices of heat because of energy cost, we're seeingescalation in prices of cooking oil. If a lot more supply comes onstream tooutstrip the demand, we can see some equilibrium coming back to these prices. Butat this point, it appears that worldwide demand seems to be outstripping therate of these supplies coming onstream.

If you look at the foreseeable future, the next 18 - 24months, it looks like structural inflation will continue in the commoditymarkets.

Operator

Your next question is from Alec Patterson - RCM.

Alec Patterson - RCM

Flat Earth, can you just give an update? How is it coming inline with expectations?

John Compton

Flat Earth has been a very stable business. It's not exactlythe size that we had hoped coming into the course of the year. But theencouraging thing about the business is that the repeat rates have been veryhigh, so it's all a matter of continuing to drive trial on the brand. Therepeat rates are some of the highest that we've had in any of the Frito-Layportfolios. We remain optimistic about Flat Earth. We have plans for newproducts to introduce behind Flat Earth for next year. I think it's a businessthat's going to continue to grow going forward.

Alec Patterson - RCM

Just on Gatorade, asyou have seen the impact weather has had here and just the pricing that youhave had to put in place versus the competition where there's been such adivergence this past year, has this caused you to recalibrate the elasticityaround Gatorade in any way? Or are you still feeling that on an underlyingbasis, it's a good, high single-digit, nearly 10% type volume category?

John Compton

Alec, we've said long term our guidance in this business ishigh single-digit growth rates. We've exited, as I've said, the fourth quarterperforming at that level and we're seeing that continue so far in the earlypart of the fourth quarter right now, and that's before G2 has hit themarketplace. There's been no shipments of G2 yet to the marketplace goingforward.

We hit a very cool, rainy period for the last two weeks ofJuly and the first two weeks of August. As you know, that's typically some ofthe hottest points in the year. That impacted our business.

Our competitor's pricing, frankly, almost is slightlyirrelevant to us. We play our game. This is a great brand. We're here to servethe needs of athletes on a 24/7 basis and we keep our attention focused on innovation.This fortunately isn't a category that has private label. Our competitor'sprice point pretty much covers that off. There's been a historical price gap of15% to 20%. That's where the brand has successfully lived before, and I thinkit can live there going forward.

Alec Patterson - RCM

So your elasticity models have not changed in that category?

John Compton

No.

Operator

Your next question comes from Robert van Brugge - SanfordBernstein.

Robert van Brugge - Sanford Bernstein

A question about Tropicana. As orange juice futures havecome down, would you expect this to start lowering your cost for this businessgoing forward? Do you expect to have to pass this through to the retailers andconsumers in the form of lower prices?

John Compton

I'm knocking on wood with my head this second, because we'renot quite through the hurricane season, as you know. But so far, I think wewould say based on what we know today, yes, we see our orange juice commoditycosts coming down. We intend to spin back against the brand. This is a brandover the last two or three years that we've had to pull back on our advertisingand our support to the brand.

As you know, it's the strongest brand in consumer packagedgoods as it relates to standing for nutrition and health and wellness, so ournumber 1 priority will be to get the brand back on air and making itincreasingly relevant with consumers for tomorrow.

Robert van Brugge - Sanford Bernstein

But would you expect retailers to be pushing for some kindof give back for the big price increases that you've taken this year?

John Compton

Robert, honestly, I don't think so because frankly, theyhave benefited from the price increases. So the profit per unit transactionshave actually increased as the pricing has increased. The orange juice pricesthat we're seeing today in the marketplace are kind of where the category wasin 1998 and 1999. So we're not well above where the business has been in thepast. The prices did come down '03, '04 and '05, but the volume really didn'trespond much from that. Se we'd rather spend back against the consumer.

Operator

Your next question comes from John Faucher – JP Morgan.

John Faucher - JP Morgan

Over the past couple years investors have given you guys ahard time for not buying back enough shares and you've had the option issue,when it's raised the shares outstanding. I guess this is the first quarter I think in about four years wherewe've seen the shares outstanding down more than 2%. Is this something that maybewe could continue to see going forward and does the better cash flow indicate agreater willingness to buy back shares?

Richard Goodman

As you know, John, we announced that we would increase theshare buyback this year to about $4.3 billion from the $3 billion that we hadthe prior year. We would expect to be buying back at those kind of levels on ago-forward basis. Yes, we will get higher leverage off of those share buybacksthan we had before because the number of shares will be decreasing at aroundthe 2% level, at least in the short run.

John Faucher - JP Morgan

That's my question, Richard, which is can that continuebeyond the short run? Yes, you announced a greater buyback, shorter term. Butcan we get one longer term?

Richard Goodman

We have authorization into 2010, I think, so yes, we shouldbe seeing it at those kinds of levels over the next several years.

Indra Nooyi

John, the key thingis we generate very, very healthy cash flow. Basically, all the cash getsreturned to the shareholders through dividends and share repurchases. We have adividend policy that's published. You know exactly what it is. Everythingbeyond dividends goes back to share repurchase. That's how we deploy the cashand the share repurchase reflects how much cash flow is generated.

Operator

Your final question is from Kaumil Gajrawala - UBS.

Kaumil Gajrawala - UBS

On SAP, you're maybe a little further along on that now, ifyou have a grasp around cost savings. You did mention that the costs were alittle higher than you expected internationally and maybe if you could give alittle color on that?

Indra Nooyi

I think the SAP implementation so far, touch wood, is goingflawlessly and I don't want to spook it, Kaumil, but so far all the releases,whether it's the U.S.or whether it's partially in Europe or whether it's in Mexico,I think the teams have done an excellent job putting SAP in.

Now in terms of the cost savings, it's hard to talk aboutcost savings now because the cost of putting in the SAP is still higher thanthe benefits we're getting out of SAP; that will be the case through 2008. In 2009 is when we start seeing some of thenet benefits.

So at this point, the cost savings are flowing as we plannedbut the cost of putting in the SAP is still higher than the cost savings thatare flowing through.

Kaumil Gajrawala - UBS

Switching gears a little bit, if you could talk a little bitabout the global economic backdrop outside of the United States, is it still asfavorable as you've been talking about in the past or are there some thingsthat you're now maybe starting to worry about?

Mike White

I haven't seen any slowdown in the emerging markets. There aresome folks that have tweaked their models a little bit for GDP growth inemerging markets, reflecting potential slowdown in the United States by maybe a half a point. But you'redealing with mid to high single-digit GDP growth rates, so a half a point iscertainly not that material.

I haven't seen in our business any slowdown in our emerging marketperformance. It continues to really drive our portfolio. So from our ownbusiness standpoint, I don't think I could say that. I think that everythingI've read and seen in talking to both economists in a number of countries asI've been traveling, I still am feeling very positive about the economicoutlook for the emerging markets for next year.

I think you'll continue to see very solid growth out ofthose markets and I don't think that the U.S.housing thing is likely to have a significant impact on those emerging markets,from what I can tell.

Kaumil Gajrawala - UBS

The topic of food inflation, to what extent do you think onthe food side, not on the other commodities, but on the food side to whatextent do you think it's partially harvest related? We've had things likeoranges. We've had a couple tough hurricane seasons, versus being just demandrelated with more demand out of Asia and such?

Indra Nooyi

Outside of oranges, it's been mostly demand driven. The cornfor ethanol program has not particularly helped. Then you've got explosivedemand for cooking oil and energy. All of these are driving the price of inputsup.

I think more and more people are shifting to wheat and oatsand going into these healthy grains and it's driving up prices of those cropstoo, because there hasn't been a structural shift in the plantings toaccommodate all of the demand. So that's what you're seeing in the marketplace.

It appears there are no more questions. I just want to thankall of you for your time and attention today, and your continued interest inPepsiCo. I look forward to speaking with you soon. Thank you.

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